REGIME CHANGE-Losing faith

YESTERDAY, my colleague wrote a nice post on the troubles in the world economy that feels a little too optimistic to me, but which gets at one interesting and disturbing aspect of the present ill wind blowing around the world economy. As a different colleague noted in conversation this morning, the 2008 crisis was by many measures less scary in comparison. It was a straightforward panic across the massive, critical financial infrastructure of the shadow-banking system. It took a while for policymakers to realise and react to the seriousness of the crisis, and that lag was a major reason for the depth of the ensuing recession.

This time around, as my colleague’s post suggests, is different. This time, a broad institutional crisis appears to be brewing. Markets may be questioning the ability of policymakers around the world to manage the macroeconomy in a non-disastrous way. Europe is the most obvious and dangerous flashpoint in this crisis, but it is by no means the only one. In America, as my colleague says, confidence was seriously rattled by last year’s debt-ceiling showdown, and it is frightening to think that an ever bigger fiscal confrontation looms ahead at year’s end. China’s economy is weakening, and while it seems clear that the government has the tools to support it, the interaction of economic weakness and political transition in a place with such opaque political institutions breeds concern. In India, the citizenry and markets are rethinking their view of the economy. It once appeared to be on a path toward steady reform and rapid catch-up growth, but the recent burst in output now looks a one-off, suggesting that there are big reform challenges—and political battles—ahead. It wouldn’t be too difficult to tell similar stories about most of the world’s large economies.

In several key economies, this institutional crisis may be contributing to a distressing monetary feedback loop. Again, Europe provides the clearest example. The European Central Bank is clearly reluctant to extend its interventions in the economy without more progress and institution-building from the euro-zone’s political leadership. But this reluctance deprives the euro-area economy of needed support, increasing the pressure on political institutions. It is possible that a similar, if less pronounced, dynamic is influencing the behaviour of the Federal Reserve.

It’s easy to oversell comparisons between the present and the interwar years; the problem is simply that there aren’t that many reasonably comparable macroeconomic eras. But there are clear parallels: significant sovereign indebtedness, difficult-to-address imbalances across an inflexible monetary regime, an economic system that had run well ahead of supporting political and fiscal institutions, central bankers seemingly at sea, and an absence of effective economic leadership. And a chief characteristic of this mess was a reinforcing cycle between economic weakness and pressure on inadequate political institutions.

This cycle might have been broken in any number of ways. In the end, it fractured, giving way to monetary regime change (the end of the gold standard and a policy of reflation) and significant political disruption: some quite benign, some horrific. It certainly isn’t difficult to imagine that the present crisis could be escaped in a relatively benign process of monetary regime change and political evolution, the latter focused in Europe, but including reform in other countries, including China and America, and in international organisations.

But both the Depression and the progression of this crisis suggest that such changes tend not to emerge in the absence of intense pressure. Reform is forged in the heat of panic and depression. In many ways, it is difficult to imagine policymakers getting ahead of the crisis and solving it without first triggering something awful to precipitate such reform—again, this applies especially to Europe but also, in its way, to other large economies and the global economy as a whole.

Of course, the particular tragedy of this crisis is that the example of the Depression is there for all to see, burned into memory. Indeed, key institutions are helmed by scholars of the Depression while other institutions are a direct legacy of the turmoil it produced. No one involved should have any illusions about where this could go if things are mishandled badly enough for long enough.

But maybe that awareness is actually baggage, a source of complacency. We may make mistakes, policymakers think, but at least we know how to avoid that. Do they? Around the world, faith in that particular truth is faltering. Restoring it without first stumbling into catastrophe may take a miracle.